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Strech Out IRA




What is a Stretch Out IRA?

Because of the opportunity for extraordinary growth, if you invest money in an IRA and find it is not needed for your retirement, you will probably be motivated to take the smallest allowable distributions from it during your lifetime. By leaving the IRA as intact as possible, over the years you may build up a substantial asset that will provide financial security for both you and your heirs. With careful planning, each of your beneficiaries can also use the same strategy by keeping his or her share in a tax-deferred environment while receiving lifetime distributions. This strategy of using an IRA to build wealth for future generations is called a stretch out IRA.

Before explaining how a stretch out IRA works, some background information would be useful. IRAs were created as a way to encourage people to save for their retirement. The rules regulating IRAs are complex, but in simple terms, they allow you to make tax-deductible contributions to a retirement account that is not taxed until you withdraw the funds. People dislike taxes, and the lure of a tax deduction for contributions and tax-deferment on growth has proved to be irresistible. Many people, particularly the wealthy, have contributed the maximum amounts allowed by law into their retirement plans.

As investments, IRAs have generally done very well. Although the value of stocks, real estate, and other assets may fluctuate wildly from day-to-day, over the course of several decades, investment returns are more predicable. For example, over the last 50 years the stock market as a whole has had an annual return of slightly more than 10%. The combination of double digit appreciation compounding in a tax-deferred environment is a financially potent mixture. Without taxes, a retirement account earning a 10% annual return will double every 7.2 years. Over a long period of time, the growth potential is remarkable.

Consider the following table that compares the value of an initial investment of $25,000 growing by 10% a year without being taxed against the same investment subject to a income tax of 30%. After a ten year period the differences start to show. The untaxed account has grown to around $65,000, about 25% greater than the taxed account. After another twenty years, the results become much clearer. The untaxed account is worth almost $271,000, double the value of the taxed account. At the 40 year mark, the difference is profound. The initial investment of $25,000 has grown to over $1.1 million, while the taxed account is less than one-third of that value.

COMPOUND GROWTH WITH AND WITHOUT TAXATION
STARTING WITH AN INITIAL INVESTMENT OF $25,000
Year 10% Annual Growth with 30% Income Tax 10% Annual Growth Without Income Tax Year 10% Annual Growth with 30% Income Tax 10% Annual Growth Without Income Tax
5 $35,064 $40,263 30 $190,306 $436,235
10 $49,179 $64,844 35 $266,915 $702,561
15 $68,976 $104,431 40 $374,361 $1,131,481
20 $68,976 $168,187 45 $525,061 $1,822,262
25 $135,686 $270,868 50 $736,426 $2,934,771

Because of the opportunity for extraordinary growth, if the money invested in an IRA is not needed for your retirement, you will probably be motivated to take the smallest allowable distributions from it during your lifetime. By leaving the IRA as intact as possible, over the years you will build up a substantial asset that will provide financial security for both you and your heirs. With careful planning, each of your beneficiaries can also use the same strategy by keeping his or her share in a tax-deferred environment while receiving lifetime distributions. This strategy of using an IRA to build wealth for future generations is called a stretch out IRA.

The cumulative amount of distributions from a stretch out IRA is mind-boggling. For example, a beneficiary who receives $100,000 at age 30 might over the course of a 52 year life expectancy receive distributions of more than $2.75 million. The following table was taken from a booklet published by The Wealth Advisory Group. It shows the total income that might be paid out to a beneficiary based on a number of different ages and starting amounts. Although I haven't independently verified the calculations, I have no reason to doubt their accuracy.

TOTAL INCOME OVER A BENEFICIARY'S LIFE EXPECTANCY
Age Life Expectancy Beginning Amount
$50,000
Beginning Amount
$100,000
Beginning Amount
$500,000
Beginning Amount
$1,000,000
5 61.9 Years $2,940,820 $5,881,640 $29,408,198 $58,816,396
10 52.2 Years $1,378,197 $2,756,394 $13,781,972 $27,563,944
15 42.5 Years $664,728 $1,329,456 $6,647,280 $13,294,560
20 33.1 Years $339,236 $678,471 $3,392,357 $6,784,714
25 24.2 Years $186,916 $373,832 $1,869,159 $3,738,318

Although the concept of a stretch IRA is simple, analyzing your situation and carrying out the details can be complicated. One problem you may have to overcome is finding the liquidity to pay federal estate taxes without having to use the IRA. Because of the growth potential of a stretch out IRA sometimes its value will represent a significant portion of your estate. Generally, this problem is best handled by holding life insurance in an irrevocable trust. This creates another source of funds that becomes available upon your death and is not subject to the estate tax.

The second problem is the type of retirement accounts you have. Throughout this article I have used the term IRA exclusively and have not referred to other types of qualified retirement plans (QRPs) such as 401(k)s. I have done this for several reasons. One reason is that it is awkward to write (and read) IRA/QRP every time I want to refer to a retirement plan. The other reason is that the stretch out IRA strategy can be carried out with virtually every IRA, while it is sometimes not possible with a QRP. This is because the plan administrator of a QRP may not be willing to administer a plan for your heirs that may go on for up to 60 years. The solution to this problem is to have someone analyze your QRP and, if it is not stretch-out-IRA-friendly, make arrangements to have it rolled over into an IRA at some point in the future.

The third problem is making the proper beneficiary designations on your IRA. Although the new proposed regulations released last year have simplified this process, it is still critical to carefully name your beneficiaries. The wrong choices can defeat the entire stretch out IRA strategy and force its distribution over a relatively short period of time.

The fourth set of problems is coordinating your stretch out IRA with your estate plan. Some of the issues are subtle, such as deciding whether the beneficiary of a stretch out IRA will be responsible for his or her share of taxes and administrative costs or whether the gift will pass free and clear of those expenses. Again, the goal is trying to keep the stretch out IRA as intact as possible.

Another estate planning issue is control and protection. Sometimes it makes sense to put the stretch out IRA in trust for the beneficiary instead of making an outright distribution. This can serve several purposes. If desired, the beneficiary can be forced to take distributions over his or her lifetime instead of having the option to withdraw all of the IRA funds at once. This restriction preserves the stretch out IRA for the beneficiary and often reflects the fact that the beneficiary has received with the stretch out IRA other inherited property under more liberal distribution terms. Keeping the stretch out IRA in trust also makes it possible to provide the beneficiary with creditor and remarriage protection. This protection is lost when the beneficiary receives an outright gift.

Although the concept of a stretch IRA is simple,you should analyze your situation carefully before deciding on a stretch out IRA. It is strongly recommended that you seek advice from a professional financial consultant.

  


  
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